When will interest rates stop rising?

Australian interest rates will continue rising until speculators stop betting that housing investments are risk-free, writes UNSW Business School's Associate Professor Konark Saxena

The Reserve Bank of Australia (RBA) said its decision to lift interest rates going forward was “finely balanced” in its June meeting. The balance between allowing inflation or hiking interest rates is starker for Australia due to the prominence of the real estate sector in our economy.  

The RBA cash rate has risen from 0.1 per cent in April 2022 to 4.1 per cent in July 2023. This is already hurting many mortgage holders. Nevertheless, I do not see the end of inflation yet and expect interest rates to increase significantly more. 

Are rent freezes a viable solution for housing stress?

Navigating low real rates: juggling inflation and real estate speculation

Despite a 4 per cent increase in interest rates, inflation remains at uncomfortably high levels. Fortunately, non-performing housing loans and personal insolvencies are at low levels according to the RBA. 

Currently, the fight against inflation needs more support than mortgage stress to achieve the fine balance required for price stability. At a 4.1 per cent nominal rate and inflation of more than 5.1 per cent, the real rate (the difference between nominal interest rates and expected inflation) is still less than –1 per cent. These historically low and negative real rates still provide strong incentives for speculators to borrow and invest in real estate, and not enough incentives to save Australian dollars to earn interest.  

At its core, the interest rate is just a number that helps balance the supply of cash savings, with the demand of dollars by borrowers. If more dollars are demanded for borrowing to invest in real estate, and not enough households want to put dollars in bank accounts to receive interest, it means that the interest rate is too low.  

Consider the trade-off between saving $200,000 dollars in a bank account or taking an additional mortgage for an investment property. With a –1 per cent real rate, how many Australians would choose to lose $2000 in real wealth a year in a bank account, compared to buying a million-dollar property and earning future capital gains? Not many Australians are that risk averse. This is reflected in the acceleration of speculators over-investing in investment properties, instead of holding a diversified portfolio. This creates an upward pressure on property prices and thereby inflation.  

How do rising house prices, influenced by monetary policy, contribute to inflation?

Initially, the RBA was hoping to contain inflation by emphasising that wages must be kept under control. However, it has recently also emphasised the role of house prices in generating inflation. This is due to the ‘Wealth Effect’, which is the natural tendency of consumers to demand more goods and services when they feel wealthier.  

When households produce more valuable goods and services, it typically increases real wealth. But when wealth increases due to monetary policy, instead of enhanced productivity, it increases the price of real goods and services, fuelling inflation.  

Read more: What happens to the economy if people can't pay their home loans?

Reviving savings appeal: a prerequisite to controlling inflation

Any policy that tries to mitigate inflation without changing the incentives to borrow versus save in Australian dollars, is likely to fail when confronted by the fundamental macroeconomic forces of equilibrium. As long as speculators see clear benefits of investing in real estate versus saving in cash, they will keep exploiting the negative real rate.  

Looking at the past success of real estate, even naïve households start believing in a “free lunch”, where housing investments can’t go wrong because the RBA will lower interest rates if house prices fall. This leads to an exponential increase in highly leveraged households who aggressively invest in multiple properties without carefully considering the future interest rate risks of their investments.   

Unless interest rates are made sufficiently high, the demand by speculators to become wealthy by taking on massive debts will overwhelm the ability of the economy to produce. As the RBA wants to slow the demand for goods, services, and labour, it will eventually need to slow the demand for debt by increasing interest rates substantially higher. 

Don’t bet against the RBA fulfilling its mandate 

Many financial analysts suggest that the RBA cannot continue increasing interest rates as doing so will send too many mortgage holders into financial distress and the economy into a recession. So, they predict that interest rates will not go much higher. This view is incomplete.  

The RBA is certainly compassionate towards mortgage holders and is relatively dovish compared to its international peers. Yet its mandate of price stability constrains its compassion. For example, despite the RBA’s guidance in 2021 that it is likely to hold rates at 0.1 per cent till 2024, macroeconomic forces have compelled it to raise rates to 4.1 per cent. 

Between compassion and mandate, it is the mandate that will eventually win. And fulfilling the mandate makes sense as it is designed to keep Australia on the path of financial stability and long-run welfare. When inflation goes out of control, it undermines the stability of the economy, the credibility of the financial system, and eventually creates social unrest. 

As is evident from the past two years, it is not wise to bet against the RBA fulfilling its mandate. Eventually, the RBA will need to increase interest rates enough to reduce the extraordinary attractiveness of real estate compared to holding Australian dollars.  

So, in my opinion, speculators should accept this, expect future interest rises till these economic imbalances are addressed, and optimise their financial decisions accordingly. This will not only reduce their individual interest rate risks, but also the risks of a higher peak in interest rates for the Australian economy. 

Subscribe to BusinessThink for the latest research, analysis and insights from UNSW Business School

In the short run, my prediction is that the RBA would need to increase it to at least 7 per cent to curb speculators from taking on more debt and betting against the RBA’s resolve. Though my hope is that speculators will end these bets earlier and interest rates don’t have to go so high. 

In any case, once such speculation is mitigated the RBA can pivot and bring rates back down to the long-run range of about 5 per cent once inflation gets back to its target range.